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AP Macroeconomics. Mechanics of Foreign Exchange (FOREX ) (Courtesy of Mr. Mayer). Foreign Exchange (FOREX). The buying and selling of currency Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell their Dollars and buy Euros.

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ap macroeconomics

AP Macroeconomics

Mechanics of Foreign Exchange (FOREX)

(Courtesy of Mr. Mayer)

foreign exchange forex
Foreign Exchange (FOREX)
  • The buying and selling of currency
    • Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell their Dollars and buy Euros.
  • Any transaction that occurs in the Balance of Payments necessitates foreign exchange
  • The exchange rate (e) is determined in the foreign currency markets.
    • Ex. The current exchange rate is approximately 8 Yuan to 1 dollar
  • Simply put. The exchange rate is the price of a currency.
changes in exchange rates
Changes in Exchange Rates
  • Exchange rates (e) are a function of the supply and demand for currency.
    • An increase in the supply of a currency will decrease the exchange rate of a currency
    • A decrease in supply of a currency will increase the exchange rate of a currency
    • An increase in demand for a currency will increase the exchange rate of a currency
    • A decrease in demand for a currency will decrease the exchange rate of a currency
appreciation and depreciation
Appreciation and Depreciation
  • Appreciation of a currency occurs when the exchange rate of that currency increases (e↑)
  • Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓)
    • Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate.
slide5

Increase in the Supply

of U.S. Dollars relative to the Euro

€ / $

S$

S$ 1

e

e1

D$

Q$

q

q1

S$ .: e (ex. rate) ↓ & Q$↑

.: $ depreciates relative to €

slide6

Decrease in the Supply

of Yen relative to the Euro

€/¥

S¥1

e1

e

q

q1

S¥ .: e ↑ & Q¥↓

.: ¥ appreciates relative to €

slide7

Increase in the Demand

for the British Pound relative to the U.S. Dollar

$/£

e1

e

D£ 1

q

q1

D£ .: e ↑ & Q£↑

.: £ appreciates relative to the $

slide8

Decrease in the Demand

for Yen relative to the British Pound

£/¥

e

e1

D¥ 1

q1

q

D¥ .: e ↓ & Q¥↓

.: ¥ depreciates relative to the £

exchange rate determinants
Exchange Rate Determinants
  • Consumer Tastes
    • Ex. a preference for Japanese goods creates an increase in the supply of dollars in the currency exchange market which leads to depreciation of the Dollar and an appreciation of Yen
  • Relative Income
    • Ex. If Mexico’s economy is strong and the U.S. economy is in recession, then Mexicans will buy more American goods, increasing the demand for the Dollar, causing the Dollar to appreciate and the Peso to depreciate
exchange rate determinants1
Exchange Rate Determinants
  • Relative Price Level
    • Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods, thus Canadians will import more American goods causing the U.S. Dollar to appreciate and the Canadian Dollar to depreciate.
  • Speculation
    • Ex. If U.S. investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Franc to appreciate.
exports and imports
Exports and Imports
  • The exchange rate is a determinant of both exports and imports
  • Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing exports and increasing imports
  • Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports
expansionary monetary policy to counteract a recession w reinforcing effect on net exports
Expansionary Monetary Policyto Counteract a Recession w/ reinforcing effect on Net Exports

Res. Ratio

Disc. Rate

Buy Bonds

ER ,therefore MS causing i% which leads to IG

=

so AD ,resulting in PL and GDPR ,making u%

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the increase in AD already caused by

the increase in IG.

cheaper

more expensive

AD = Aggregate Demand

PL = Price Level

GDPR = Real Gross Domestic Product

u% = Unemployment Rate

S$ = Supply of Dollars in FOREX

M = Imports, XN = Net Exports

ER = Excess Reserves

MS = Money Supply

i% = Nominal Interest Rate

IG = Gross Private Investment

D$= Demand for dollars in FOREX

X = Exports

contractionary monetary policy to counteract inflation w reinforcing effect on net exports
Contractionary Monetary Policyto Counteract Inflation w/ reinforcing effect on Net Exports

Res. Ratio

Disc. Rate

Sell Bonds

ER ,therefore MS causing i% which leads to IG

=

so AD ,resulting in PL and GDPR ,making u%

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the decrease in AD already caused by

the decrease in IG.

cheaper

more expensive

AD = Aggregate Demand

PL = Price Level

GDPR = Real Gross Domestic Product

u% = Unemployment Rate

S$ = Supply of Dollars in FOREX

M = Imports, XN = Net Exports

ER = Excess Reserves

MS = Money Supply

i% = Nominal Interest Rate

IG = Gross Private Investment

D$= Demand for dollars in FOREX

X = Exports

slide14

Expansionary Fiscal Policy Side-effect: ‘Crowding-out’ of Investment and Net Exports

A possible side-effect of increased government spending

and reduced taxes is a budget deficit which may lead to

the ‘crowding-out’ of Gross Private Investment (IG) and

Net Exports (XN)

When G or T , then government must borrow in order to continue

spending. This leads to an increase in the demand for loanable funds

or a decrease in the supply of loanable funds, which results in r % .

This change in r % leads to IG . In addition, the increase in r% causes

D$ and/or S$ as investors seek higher returns in the U.S. This leads to

$ which leads to X and M , so XN . Because IG and XN are direct

components of AD, these decreases offset some of the increase in AD.

Don’t understand loanable funds? Click here

slide15

Contractionary Fiscal Policy Side-effect: ‘Crowding-in’ of Investment and Net Exports

A possible side-effect of decreased government spending

and increased taxes is a budget surplus which may lead to

the ‘crowding-in’ of Gross Private Investment (IG) and

Net Exports (XN)

When G or T , then government develops a budget surplus

This leads to a decrease in the demand for loanable funds

or an increase in the supply of loanable funds, which results in r % .

This change in r % leads to IG . In addition, the decrease in r% causes

D$ and/or S$ as investors seek higher returns abroad. This leads to

$ which leads to X and M , so XN . Because IG and XN are direct

components of AD, these increases offset some of the decrease in AD.

Don’t understand loanable funds? Click here